In my opinion, the world is built on balances, and so finance sector is nı exception. There should be a balance between the free market competition among the banks and the control of the regulatory bodies over the entire system. Yes, banks' risk appetite can be dangerous sometimes, mainly due to the pressure of making more and more profit. On the other hand, if there were no competition at all, who on earth would care for better customer services and better pricing? Just think of many innovative banking services that we all enjoy today such as internet banking (yes, do not take it for granted), call centers, deferred repayments for installments, money saving credit cards, etc. Would they still be around even if there were no competition?

I just had an abusurdly Sci-Fi thought:
Water(H2O), Gas(CH4), and Electricity, and a few other key elements, can sustain life no matter where you are in the Universe (though exact amounts required to do so vary, as well as how to combine them)

So, maybe we can base a global currency based on a basket of these elements plus water, gas, and electricity. This will make Smart Grid the next generation of FINANCIAL infrastructure...

Some sectors are better run as strictly monitored and regulated monopolies for precisely this purpose. Also, slowing down the industry to a monitorable and regulatable pace is strongly recommended in case of the Financial Sector. Only the Financial Sector itself will suffer from such slowdown, and they deserve it!

Andrew, actually the nature of banking makes it unstable. Fractional reserve banking is always unstable. Read Huerta de Soto's "Money, Bank Credit, and Economic Cycles." A pdf version is free at mises.org/books/desoto.pdf. Or read Hayek's "Monetary Theory and the Trade Cycle" also in pdf at mises.org.

There are no good solutions to the instability caused by fractional banking. Free bankers believe that competing currencies would solve the problem and they could be right. We just don't have any long term experience with it. Others insist on 100% reserve banking, but as Hayek wrote, that ain't never gonna happen. A gold standard won't help because the problem is credit creation, not paper money creation. That's why we still had booms/busts every decade for centuries under the gold standard.

My personal preference would be to try free banking, but that's a very dark horse in the race. The alternative today is to look at the recent experience of the "great moderation." I believe we went for a decade without a crisis because the Fed was humble and didn't try to rescue us from every crisis or boost the economy too much. That was due mostly to the influence of the late great Milton Friedman.

Pacer, that's a good point. Either people run scared in a free market, or they succumb to a false security that the state will protect them. State security is false because 1) regulatory capture ensures that regulators are looking out for the interests of the biggest banks, not the little banks or the consumer, and 2) regulators simply never know enough. Regulations today are too numerous and contradictory. Regs in a totally unrelated area can affect banking.

If regulatory capture was impossible and regulators had the ability to understand all regulations that affect banking, and sort out the interactions and conflicts, then I would agree. Let's have more regulation. But Adam Smith addressed the first part: regulatory capture is the nature of the beast and it will never change. Hayek wrote about the second: information is too vast and deep for any group of regulators, even with super computers, to manage things.

The benefits of stronger competition on financial markets is cheaper financial services for customers, not increased stability.

Imagine you have one single bank in the world which has a monopoly over all financial services. This bank would only lend to the most risk-free customers and still be largely profitable as it could charge basically anything as there are no competitors to push prices down. A bank without competition would never collapse but still, I think it's pretty clear it would definitely not be beneficial to society.

I don't think regulators could replace competition to ensure healthy financial industry. Actually I'd argue that if there was no interference of various regulators, local lobbies etc the whole financial sector might have not experienced such bumpy years lately.....

In gambling except totocalcio tipsters and bookmakers, whatever they want to do to manipulate, have little effect on the results while in the financial world credit-rating agencies can theoretically turn to become provocateurs and doommongers only arbitrarily beneficial to some investors who are exclusively accessible to low-downs and a faster computer for automatic trading. A sheerer competition among those agencies, who rate their clients, would result in that kind of corruption and constraint in the face of pressures visible or invisible, but it is usual that salesmen are more likely to flatter or rebate to their clients in a sheerer competition because this is a better service for their clients. Where there is a will there’s always a cheat. This is not unique to the industry at all. It is also needless to say that more stringent regulation is necessary.

The crazy thing particular to credit rating is that there seem to have been a number of academic works published in an attempt of convincing us ordinary people that those agencies act 'sufficiently' clean and autonomous while we have been continuously doubtful of that assertion since the first place. So, we have been having to use our own individual literacy instead of regulation, and will have to.

You raise a good point on de facto nationalization. But I think we can all agree that the present situation of privatized financial industry profits and socialized losses is neither desirable or sustainable.

Perhaps the best course is to remove all shackles (regulations) and supports (GSEs, preferential access to the Fed, possibility of bailouts) and let the system police itself. The customers would then be so properly scared to deal with the sector that banks would be forced to implement their own safety nets and means of protecting customers. Better that they do so with their own dime and not the taxpayers' though.

If we are going to look at the problems with the rating agencies, might not the place to start be that fact that their market is massively fed by government regulation?

Suppose you are a bank, or a pension fund, or any of several other kinds of entity -- making up the majority of the market for bonds. You are only allowed to buy bonds of a specific rating. Which means that, to sell bonds, the issuer has to have them rated. Which, currently, means that the issuer has to pay the rating agencies. Talk about a captive market.

1975. So, plausibly, institutional memory of how to do it with integrity fades over the next 25 or 30 years in the ratings agencies, but it's too long of a time span to call it an obvious cause-and-effect smoking gun.

This is good, too: "“In the truly procompetitive and best case, not only would the term ‘NRSRO” be dropped, but the regulatory requirement of designation of approved rating agencies itself would be eliminated. That requirement has produced unintended effects never imagined when it was introduced in 1975, and it is time for it to retire." http://www.aei.org/speech/22771

rewt66, According to Mish "Low and behold the SEC came along in 1975 and ruined a perfectly viable business construct by mandating that debt be rated by a Nationally Recognized Statistical Rating Organization (NRSRO). It originally named seven such rating companies but the number fluctuated between 5 and 7 over the years....It turned upside down the model of who had to pay. Previously debt buyers would go to the ratings companies to know what they were buying. The new model was issuers of debt had to pay to get it rated or they couldn't sell it. Of course this led to shopping around to see who would give the debt the highest rating." at http://globaleconomicanalysis.blogspot.com/2007/09/time-to-break-up-cred...

Pacer, why not just nationalize the banks? If you want state regulators to decide everything, then why not just have the state own the banks? Control equals ownership. If the state controls every aspect of banking, then the state in fact owns the banks, even if we keep up the charade that banks are privately owned. So why not just end the charade?

Wow this is really stupid. I haven't read the papers and won't unless someone can give me a reason. Did the authors really look at competition only? What about incentives? Under normal circumstances, people won't pay for lower quality results. There have to be some pretty strong incentives to pay more for less quality. Ratings agencies had them. The Feds required banks to use those three agencies and no others for their ratings. So the Feds gave the three ratings agencies a cartel. They enjoyed a guaranteed market for their services and there was nothing the banks could do about the poor quality. At the same time, the buyers of their services wanted poor quality work, and they could get it as long as the Feds force fed banks the results.

The story is about incentives and unintended consequences created by government intervention, not competition.

I agree that increased competition incentivises increased risk taking. Normally, in a capitalist system, this is a good thing. The problem when it comes to banks is not so much that they are incentivised to seek more and more profit (that is good) but that they are taking risks with assets that are not their own (bad). Banks are in the position of a fiduciary -- they hold money in trust for depositors. Even investment banks have a fiduciary duty, as they are holding money for the benefit of their investors. It is this fiduciary duty that is supposed to provide the necessary break on overly-risky activity. However, I see very few banks and financial firms being held accountable for breaches of their fiduciary duty.

Right now, our regulatory structure provides all incentives for risk taking, but no real penalties for bad consequences (i.e. the banks get bailed out of their mistakes, and nobody sues the banks or otherwise punishes them for irresponsible behavior). If ratings agencies could be held liable for grossly inaccurate ratings, or if investment banks could be held liable for selling securities that cannot be accurately valued, then I think they would curb their own risk-taking and become more conservative, balancing out the incentive for risk-taking created by increased competition.

The problem with the rating agencies was that a degree of competition was introduced while still maintaining the oligopolistic structure of the rating agency industry. Risk is increased to compensate for decreased profits, but the agencies can remain confident that the cost of any failures that result from those risks will be borne by other participants. After all, if they fail, who will replace them?

I am not necessarily opposed to stronger regulation of rating agencies, but if those regulations reinforce the security of the established players and maintain their oligopoly, less rather than more competition is probably preferred. If their oligopoly is to be broken up and new participants allowed to enter the field, more competition would be desirable as failed firms can easily be replaced. (The idea of deregulating rating agencies, given their impact on other market participants, should probably be approached with caution though.)